Global Perspective: FOMC meeting preview

Charles St ArnaudSenior Investment Strategist

The US Federal Reserve is holding its last Federal Open Market Committee (FOMC) meeting of the year on 13 December. We and the market widely expect the FOMC to increase its policy rate by 25bps to 1.25%-1.50%. Key for investors now: what impact will the planned fiscal stimulus have and how many rate hikes will there be next year? On the latter we believe investors may need to reprice their expectations.

A December hike would surprise few

This intention of the Fed to increase the interest rate in December has been well communicated to investors, with FOMC participants continuing to highlight over recent weeks the ongoing strength of the economy and tightening of the labour market.

Given this, the main points of focus for investors will be the December Summary of Economic Projections, the last press conference of Chair Yellen and the impact from the changes to fiscal policy on monetary policy.

Expected changes to the December Summary of Economic Projection

The main changes to the US economy since the release of the September projection have been:

The economic data received over the past 6 weeks or so has been generally better than expected

Congress is on the verge of passing a tax bill that will significantly lower taxes. Moreover, there is also an increased likelihood of higher spending next year.

In line with the sustained economic momentum and the strong incoming data, we believe that the growth forecast for 2017and 2018 is likely to be revised higher. However, it is not clear whether FOMC will have incorporated the impact of the changes to the tax system in their forecast or whether they will wait for the changes to be signed into law before doing so. This is likely to be addressed at the post-meeting press conference.

The forecast for the unemployment rate is likely to be lowered somewhat over the projection horizon. While this is in part due to the stronger growth expectations, it is mainly the result of the incorporation of a lower starting point. The unemployment rate stood at 4.4% at the time of the September projection, compared to 4.1% currently.

On the inflation side, the core Personal Consumption Expenditures (PCE) measure remains below the FOMC’s target and its end of 2017 expectations, however, the gradual increase in recent months could provide some comfort to the FOMC in its projection that we have now seen the bottom in core PCE inflation and would mean an unchanged projection. For headline PCE, the risk is that the increase in oil prices could mechanically push the projection for 2018 higher.

FOMC’s policy rate expectations

The distribution of the dots and the median path for the policy rate in the December projection are very uncertain. Nevertheless, we believe that the FOMC may want to refrain from sounding too hawkish by both hiking rates and raising the projection for the policy rate. As such, we continue to expect three hikes next year – this is still more aggressive than the current market expectations of a little less than two hikes next year.

That said, only three FOMC members would need to push their 2018-year-end policy rate projections above 2.25% to change the median expectations, meaning that there is a risk that the median projection could switch to four hikes next year. Moreover, it is not clear if FOMC members will internalise the change to fiscal policy in their projection and whether it would justify a more aggressive rate path. With the median projection for end-2019 unlikely to be changed in our view, an increase in the number of hikes in 2018 would mainly reflect some tightening being brought forward.

Press conference: all eyes on the fiscal stimulus

The December meeting will be the last press conference for Chair Yellen, but her penultimate FOMC meeting (her last meeting will be on 31 January). We think that the main information the market will be looking for is how the FOMC believes the upcoming new tax law will affect the economy and whether it is incorporated in the December projection. As such, any indications as to whether the fiscal plan will be affecting mainly the supply side of the economy or the demand side will be important in gauging the impact on growth, the amount of slack in the economy, the effect on inflation and, ultimately, the FOMC’s response to the fiscal changes.

Market perspective

The impact on financial markets of this week’s FOMC meeting is likely to be minimal, in our view. The widely anticipated 25bp hike has been well communicated and fully priced into investment markets for some time. We believe the risk for the market mainly lies in its lack of belief in the FOMC’s capacity to hike rates in 2018. At some point, likely next year, a convergence between market expectations and the FOMC will be needed, in our view. This could have some big implications for the rates market and the USD.